Interest rates - how high will they go?

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With the economy in growth mode, more interest rate rises are on the horizon, writes Peter Weekes.

Hold on tight, it's going to be a bumpy ride ahead. That's the consensus view among economists - although just how rough it will be and how long it will last is a matter of much heated debate.

On the bear side is BIS Shrapnel, which is forecasting interest rates to peak by late 2006, with the Reserve Bank's cash rates hitting about 8 per cent. That's an extra 31/4 percentage points, or $550 a month, on a $225,000 home loan. At the other extreme are those discounting any need for a rate rise, now or in the "foreseeable future". Most of the rest are predicting a rise of a 1/4 percentage point after the election, followed by a similar one early next year before reductions from late 2006.

The trick for investors is in picking the right view, as most scenarios require their own portfolio-weightings strategy.

Australian investors have had a dream run over the past 14 years. The economy has been growing at about 4 per cent, interest rates are at historic lows - despite two small rises late last year - unemployment is near 23-year lows and inflation is within the RBA's target range of between 2 per cent and 3 per cent.

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Still, there are clouds on the horizon, raising the spectre of a return of inflation and higher interest rates. This week the Reserve Bank bluntly warned that rates could rise in the near future, the US Federal Reserve did hike its rates by a 1/4 percentage point - the second such rise this year, albeit from a low base of 1 per cent, with forecasts of three more similar rises this year - and world oil prices hit record highs.

Economists are divided on the meaning of the RBA's statement that "it would be surprising if Australian interest rates did not have to increase further at some stage in the current economic expansion".

BIS Shrapnel chief economist Frank Gelber says it signals a rates push, peaking at around 8 per cent by mid-2006.

"During this year we will see demand-inflationary pressures in both product and labour markets, which will cause the Reserve Bank to significantly tighten monetary policy (raise rates)," he says.

"Some people think the Australian economy is very sensitive to interest rate rises, and there are some parts of the economy which are, but by that time (mid-2006) we are going to have a business investment boom bubble on our hands and business is not very sensitive to interest rate rises."

The problem with relatively high interest rates for an extended time is the increased likelihood of recession. Former treasurer Paul Keating found this out when the RBA kept rates around 18 per cent during the late 1980s and early '90s.

"In fact, that is what we are forecasting for the end of the decade," says Gelber.

Others are not nearly so bearish, and argue any inflationary threat from high oil prices or a wages push from the tight labour market can be contained without, or with only a small, rate rise.

Citigroup Asset Management's head of equity strategies, Brian Parker, says BIS Shrapnel's forecasts are far too aggressive. He says the RBA would consider that level of rates only if inflation was running at about 5 per cent, "but we just don't live in that sort of world any more".

"We live in a world of low inflation and much higher debt levels; that means interest rates have more impact. The Reserve would be well aware of the damage those sorts of (high) interest rates would cause."

He points to the nation's debt-servicing ratio, which hit a record high in the three months to March, with households using 9.4 per cent of their disposable income to meet interest payments on their loans. When rates were 17.5 per cent in early 1990, the debt-servicing ratio was 8.6 per cent.

"It does suggest that consumers were much more interest-rate-sensitive than they have been because of household debt levels," says Parker.

"Although the Reserve has a bias to tighten, as long as we continue to see house prices gradually coming off, new loan approvals falling and a slowing of credit growth, that should allow the Reserve Bank to hold off. If we don't see that, then the Reserve will likely raise rates later this year."

The pace of credit growth has abated slightly to an annual 18 per cent over the first half of this year, compared with 21 per cent in the previous half. Still, the RBA warned this week that despite the burden of debt, the nation's cash registers are still ringing, with consumer confidence at a decade high.

CommSec's chief equities economist, Craig James, says the RBA is trying to "jawbone" consumers and borrowers. He says the RBA will be watching two things before moving on rates: housing prices and oil prices.

At the moment, the high oil price is acting like a rate rise by taking money out of pockets, and is cited as the reason the RBA has not moved on rates.

ANZ chief economist Karen Pringle, who thinks this phase of rate tightening will continue to late 2006, says oil is the single most obvious risk to investment markets. If oil hits $US55 a barrel for a sustained period (the same in real terms as during the first Gulf War), "it would have serious consequences for the global and therefore Australian growth outlook," says Pringle.

"High oil prices don't have an immediate affect on economies, but they do if they are sustained at a high level for long enough. It remains the single biggest risk, and that is because it has an inflationary impact," she says.

Sustained high oil prices will also hit company profits, leading to a fall in valuations on the stockmarket, says Citigroup's Parker, who recommends investors go overweight in local bonds, staying clear of foreign bonds where the interest rate outlook is tightening.

He says in a world of historically low inflation, the yields investors can get from Australian bonds are "relatively rare and quite attractive" compared with international bonds.

This is because the RBA has finished or almost finished raising rates compared with other nations, the budget is in surplus, and the Federal Government is not carrying substantial debt.

Pringle agrees that "bonds will probably give a good return to investors".

James says "all roads lead to the Australian sharemarket" due to the market's "cheap valuations".

"It is hard to find value in other asset classes," he says.

For different reasons, BIS Shrapnel's Gelber also prefers shares over bonds, saying the value of bonds will fall as rates rise.

"You will be investing to make a capital loss," he says.

"The sharemarket is going to be strong. Strong profitability and strong growth driving a strong equity market.

"I'm not promising it year by year, but the next couple of years will be very kind to the stockmarket," he says, forecasting double-digit returns.